Lending in China appears to be levelling off after picking up speed from mid-2015. Bank lending rose only 14.4% in May and should continue to ease, with the Chinese government ratcheting back its economic stimulus versus the first quarter of 2016. This should reassure investors that the government is serious about reining in the country's debt. But newly created credit is being used mainly for infrastructure-related purposes rather than for supporting the economy's shift towards services and consumer spending.
The government can also be lauded for the restrictions it has imposed on the shadow-banking sector. These seem to be paying off, as total social financing – a broad measure of lending that includes some of these off-balance sheet vehicles – has slowed to +12.6%. This improvement is due in part to a reduction in bankers' acceptance bills – instruments designed to serve as commercial guarantees but often used to back off-balance-sheet loans.
The growing gap between the M1 and M2 money supply is a red flag when it comes to the use of liquidity in China's real economy. Companies with capital spending plans usually park their liquidity in financial instruments that can be easily converted into cash, like demand deposits – which are a component of M1. If they do not have capital projects in the pipeline, they tend to place their cash in less liquid instruments that earn more interest, such as money-market funds or savings account – which are components of M2. So when M1 grows faster than M2 – indicating a preference for instruments that can be easily converted into cash – companies usually have spending projects in the works. Historically, China's industrial production sector has conformed to this trend.
Since 2015, however, the disconnect between these two variables suggests that the liquidity held by companies is not necessarily being channelled to capital spending any more. A number of factors are at work here, one of which is that companies are discouraged from investing by persistent overcapacity in the manufacturing sector.
Sooner or later, the Chinese government will have to address this problem of surplus capacity, failing which future credit creation will lose its punch.